Strong Jobs, Muted Wage Gains Ignite Stock Rally

So observed our old pal Ed Hyman’s outfit, Evercore ISI, Friday after five tumultuous weeks to which the monthly jobs reports served as bookends.

It seems like ages ago, but it was just Feb. 2 when the January employment numbers set off convulsions that shook markets globally. News that American workers finally were getting raises of nearly 3% from a year earlier aroused worries about a liftoff of inflation, and with it faster increases in interest rates.

That stirred previously somnolent volatility, thereby upsetting some not-so-well-laid investment plans that assumed this long-dormant volcano would never erupt. And so we learned about previously obscure exchange-traded instruments that let discount-store workers and assorted other punters make bets once confined to sophisticated derivatives traders, which blew sky-high when mishandled. The resulting selloff put the major stock averages into correction territory, leading some to write the bull market’s obituary.

Not so fast. News came this past Friday morning that American businesses went on a veritable hiring spree in February, expanding their payrolls by 313,000, half again what economists had projected and the most since July 2016.

Wall Street, for once, didn’t begrudge that good news for Main Street, as those job gains weren’t accompanied by a surge in pay to stoke fears of inflation and bigger interest-rate increases. The higher demand for labor was met with increased supply, so pay gains didn’t pick up. (That was the story last month, anyway. Click here for an analysis of looming labor shortages.)

Specifically, the February household survey (which is separate from the establishment series that provides the payroll numbers) showed the labor force swelled by 806,000 folks last month, of whom 785,000 found jobs. That happened because the labor-force participation rate rose to 63% of the adult population, still a historically low level but a marked improvement from 62.7% in January. All of which left the headline unemployment rate unchanged at 4.1%.

But the big news the markets focused on was a 2.6% rise, year to year, in average hourly earnings. That marked a deceleration from the revised 2.8% year-on-year increase posted for January, down from the originally reported 2.9% number that freaked out the markets.

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However you slice and dice the data, the February jobs numbers didn’t do anything to upset expectations about the Federal Reserve’s course of interest-rate hikes this year. The January numbers reported early last month aroused fears of four quarter-point increases in the federal-funds target rate, and even five by a few Fed watchers, as opposed to the three hikes indicated by the most recent “dot plot” of projections published at the December meeting of the Federal Open Market Committee.

After Friday’s jobs report, the fed-funds futures market was still predicting three increases for 2018, starting with a move of at least a quarter-point, from the current target range of 1.25%-1.50%, being priced in with 100% certainty for the March 20-21 FOMC meeting, according to Bloomberg data. Another rise of at least a quarter point at the June 12-13 meeting is given 77.1% probability.

A third increase, at the Sept. 25-26 confab, gets only a 53.4% probability, but rises to a 72% chance by the Dec. 19 meeting. But the odds of four hikes this year gets only about a one-in-three chance (34.4%, to be exact).

“We don’t see any strong evidence yet of a decisive move up in wages,” Fed Chairman Jerome Powell said in testimony to the Senate Banking Committee the previous week, a view corroborated by the latest data.

The jobs numbers vindicate former Fed Chair Janet Yellen’s policy to go slow in raising rates, writes JPMorgan Chief U.S. Economist Michael Feroli. But with the participation rate among prime-age (25-54-year-old) workers back to near prerecession levels, we are closer to the end than the beginning of running a “high pressure” policy to lure idle folks back into the labor market, he adds.

Yet Peter Boockvar, chief investment officer at Bleakley Advisory Group, says that a hike at this month’s FOMC meeting would take the fed-funds rate to only 1.50%-1.75%, “a ridiculously low rate for these types of job numbers at this stage of the expansion.” He thinks the Fed will be forced to play catch-up.

The stock market wasn’t having any rate jitters as it marked the bull’s ninth birthday Friday with a record close for the Nasdaq Composite, which came roaring back after the earlier correction with an 11.6% rebound from the Feb. 8 low. The Dow Jones Industrial Average ended the week short of its late January peak despite a robust rebound of 6.2% from the Feb. 8 session. The Standard & Poor’s 500 index has recovered 8% from that date but also remains short of its record.

So the week ended with strong gains on Main Street for jobs and on Wall Street for stocks. And to top it off, President Donald Trump accepted an invitation sit down with North Korea’s leader, Kim Jong Un, for talks on its nuclear weapons program. What a difference a month makes.

Not everything has changed in the past month, however. Jim Bianco, who heads Bianco Research in Chicago, has been dissecting what he describes as a “regime change” in the financial markets. To give away the ending: Bonds no longer are likely to be stocks’ savior.

It always had been that whenever stocks would tank, bonds would rally, in large part owing to the expectation that the Fed would ease policy whenever things got dicey for equities and risk assets. Actually, that expectation dates from 2001 to 2017, which Bianco describes as a deflationary period.

So a traditional 60% stock/40% bond portfolio worked because something was always rallying. The one exception was in 2013 during the “taper tantrum,” when the Fed announced it would end its securities purchases, and stocks and bonds fell together on the prospect of slowing central bank liquidity.

This year has seen an end to this negative correlation between Treasuries and equities, Bianco told clients in a conference call last week. In 2018, “the defining characteristic so far is the return of inflation and the market’s fear that Fed/central banks are going to remove stimulus faster than anticipated,” according to documents distributed for the call.

This regime change resembles the period from 1966 to 2001, and especially the 1990-99 span. During that time, stocks and bonds tended to move together, with inflation and interest rates driving both. Stocks basically went nowhere from the go-go period of the late 1960s until the early 1980s as double-digit inflation drove up bond yields to historic records during the 1970s. Then, the great bull market started in the early 1980s with the break of the inflationary fever, which made for the historic decline in bond yields that lifted equities.

In this century, markets shifted to a risk-on or risk-off mode, benefiting either stocks or bonds, respectively. The traditional balanced portfolio handily covered either scenario, limiting drawdowns even in extreme episodes, such as the 2008 crash. Treasury bonds rallied, partially offsetting the decimation of stocks and other risk assets.

The availability of low-cost index mutual funds or exchange-traded funds made constructing balanced portfolios simple and inexpensive—especially compared with high-fee hedge funds or other pricey products.

One sign this paradigm was changing came in last month’s market maelstrom. Bonds became the dog that didn’t bark; they failed to rally when stocks got slammed and the Cboe Volatility Index, aka the VIX, soared following the January jobs report.

Previously, Bianco writes in an email, every spike in volatility and the VIX would lead to a risk-off rally in bonds, which would then dampen volatility. When bonds failed to jump after a 40% uptick in the VIX, to 14 from 10, investors realized it was different this time and scrambled to dump investments to short the VIX. The short-VIX unwind and rise in volatility then led to a 1,000-point one-week drop in the Dow.

This was a sign of a regime change, from the deflationary one in which bonds rally when stocks drop, to one in which bonds don’t bail out an equity portfolio. As inflation expectations rise, so will expectations of central-bank rate hikes, Bianco says. At the same time, stock and bond markets face the end of “central bank largesse” in the form of their asset purchases. The Fed has already begun to pare its securities holdings. Bianco cites a
Deutsche Bank
projection that the Fed, the European Central Bank, and the Bank of Japan cumulatively will cut back their purchases this year and begin to shrink their balance sheets in aggregate in 2019.

That’s when he sees the regime change really hitting investors, with bonds no longer serving as a hedge to their equity portfolios. Only one hedge remains in that case, cash—or, more precisely, money-market instruments. They won’t increase in price, as bonds had during times of stock declines, but they will hold their value. A six-month Treasury bill yields 1.88%, virtually the same as the S&P 500. The T-bill provides no gain, but also no pain; more important, it adds stability to a stock portfolio to keep an investor from fleeing the market when things get rocky.

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